Investing in the Energy Sector with MLPs

published: Sep. 29, 2014

As many investors have been considering adding, or increasing, allocations to the Energy sector in 2014, energy-oriented Master Limited Partnerships (“MLPs”) have garnered a lot of attention. While MLPs are not a new investment vehicle (in fact the first MLP – Apache Oil Company – was launched in 1981), they do represent a different type of investment to many investors and financial advisors. As a result, we thought it would be invaluable to provide a broad overview of the different types of MLP investments currently available in the marketplace to help investors make more informed decisions in this area.

Basically, a MLP is a limited partnership that is publicly traded on a given exchange. MLPs are often recognized for their tax benefits since they are pass-through entities that generally avoid corporate income tax at both state and federal levels since they are classified as partnerships. To qualify for these tax benefits, MLPs must earn at least 90% of their income from “qualified sources” as per the guidelines published by the Internal Revenue Service (“IRS”), such as natural resources. According to the National Association of Publicly Traded Partnerships, qualifying natural resources include:

Oil, gas and petroleum products

Coal and other minerals

Timber

Any other resource that is depletable under section 613 of the federal tax code

Industrial source carbon dioxide

Ethanol, biodiesel and other fuels (transportation and storage only)

MLPs are required to make distributions to their unit holders; which include limited partners and general partners, on a quarterly basis. As a result, MLPs can often be worthy of consideration for those investors who want exposure to the Energy sector in addition to a higher relative level of tax-advantaged income.

There has been an ongoing shift from the types of MLPs outstanding towards the energy sector over the years, primarily due to the on-going redefinition of qualified sources of income.

MLPs Industry Concentration Metrics (Partnerships, 2013)

MLP Industry Concentration

1990

2013

Oil and Gas Midstream and Downstream

10%

51%

Oil and Gas Exploration & Production (Upstream)

21%

12%

Propane

0%

3%

Oil & Gas Marine Transportation

1%

5%

Coal Leasing or Production

0%

4%

Other Natural Resources

5%

7%

Real Estate – Income Properties

14%

2%

Real Estate – Developers, Homebuilders

4%

0%

Real Estate – Mortgage Securities

13%

2%

Hotels, Motels, Restaurants

12%

0%

Investment / Financial

6%

9%

Other Businesses

15%

4%

There are three major categories of Energy MLPs, each with their own set of characteristics and nuances.

Different Types of Energy MLPs

Upstream MLPs – primarily involved in the exploration, recovery, development and production of crude oil, natural gas and natural gas liquids.

Midstream MLPs – primarily involved in the gathering, storage and transportation of oils and gases. Pipelines are one such example of a midstream transportation operation. We often refer to midstream MLPs as “toll takers” as they earn their money based upon the storage and transportation of the fuels and are their valuations are not as influenced by price volatility of the underlying fuels themselves or the unpredictability of the exploration and development process overall. The majority of the MLPs currently available in the marketplace; energy and non-energy based, focus on midstream operations.

Downstream MLPs – primarily involved in the distribution of the fuels to end customers, which include residential, industrial and agricultural entities.

According to Bloomberg, as of September 23, 2014, there are 141 MLPs available in the marketplace today. However, there are also several other MLP investment strategy delivery vehicles for investors to consider. These include, but are not limited to, open-end mutual funds, exchange-traded funds (ETFs) exchange-traded notes (ETNs), closed-end funds (CEFs) and unit investment trusts (UITs).

MLP ETFs/ETNs = approximately 23 products

MLP CEFs = approximately 26 products

MLP Mutual Funds =approximately 22 products

MLP UITs = approximately 6 products

As with other packaged products, structure matters and understanding the differences in product structures as it relates to MLP investment vehicles is important due to their potential impact on after-tax total returns. Structural options include registered investment companies (“RIC”) or C Corporations (“C Corp”). Here is a summary from Prudential Investments of the key differences between RIC and C Corp structures as it relates to mutual funds but can be applicable to other fund vehicles as well:

MLP Mutual Funds

Mutual funds have been allowed to invest in MLPs since 2004. Many investors prefer the single 1099 tax form associated with a mutual fund over the onerous tax implications for individual MLP investments. Depending on how a mutual fund is structured for U.S. federal income tax purposes, there may be restrictions on MLP investments.

RIC Structured MLP Mutual Funds

Most traditional mutual funds are structured as Regulated Investment Companies (RICs) and are shielded from entity-level taxation. But in order to maintain this favorable tax structure, a RIC must, among other requirements, limit the amount it can invest in “qualified publicly traded partnerships” (i.e. MLPs) to no more than 25% exposure.

C Corp Structured MLP Mutual Funds

Mutual funds that fail to qualify as a RIC are instead treated as a regular corporation, or a C Corporation (C Corp). A C Corp mutual fund has no holding restrictions and therefore is the only mutual fund structure that could potentially offer a “pure play” (i.e. greater than 25% exposure) MLP investment strategy.

C Corp structured mutual funds are subject to federal, state, and local taxes on an entity level (i.e. the Fund level). This tax liability is a combination of ordinary income and realized capital gains the C Corp earns on its investments and its unrealized capital gains captured by the entity’s Net Asset Value (“NAV”) as a deferred tax expense.

Mutual Fund Shareholder Tax Effects

Regardless of whether an individual invests in a C Corp or a RIC structured mutual fund, shareholders are required to pay taxes on all fund distributions that are not deemed as Returns of Capital (“ROC”). This includes ordinary income, such as from dividends, and net realized capital gains at the time of final sale.

Energy/MLP Sector Outlook

We, at Hennion & Walsh, are optimistic about future growth potential within the Energy sector, and for MLPs in particular. Our viewpoint is based in part on the increased production levels that the energy market in the U.S. has witnessed as a result of new technologies, specifically related to drilling and fracking activities. These increases in production have benefitted those underlying commodities that are associated with many of the MLPs available today and discussed in this post. Looking ahead, we believe that there is growing likelihood that the U.S. will become a net energy; oil and natural gas energy, exporting country over the next decade. We are not alone in our viewpoint as others seem to also be optimistic about the U.S. achieving energy independence in the not so distant future. For example, according to a MarketWatch article entitled, “North America energy independent by 2020, but still tied to markets”, consultant Wood Mackenzie predicted that North America will become a net energy exporter by 2020. Sharing a similar prediction, Citigroup Managing Director Edward Morse forecasted that the gas and oil boom, combined with improved efficiency, will make the U.S. a “net-zero importer “of energy by 2020 according to a Forbes article entitled, “U.S. will Meet Energy Needs by 2020: Citi Researcher.” Certainly there are a variety of factors which could cause our viewpoint and these forecasts/predictions to not be realized. Additionally, in order to achieve this level of energy independence, the U.S. will need to continue to invest significantly in our own energy infrastructure capabilities. However, such investments would stand to likely benefit some of the different types of MLPs (i.e. upstream, midstream and downstream) further in our opinion.

It should be noted that as with other sectors and investment product strategies, investments in MLPs offer their own unique set or risk factors that should be understood before any potential investment is considered.

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Disclosure: Hennion & Walsh currently has allocations within its SmartTrust® Unit Investment Trust (UIT) platform consistent with the investment theme discussed in this article. Capital Innovations is a Portfolio Consultant to Hennion & Walsh on the SmartTrust®, Capital Innovations Global Infrastructure & MLP Trust strategy. This article is for educational purposes only and should not be considered as a solicitation to purchase or sell any of the security types or strategies mentioned. As a reminder, past performance is not an indication of future results.